For 20 years, before I liberated myself from corporate America, I spent a hell of a lot of time doing business and market analysis (e.g. why are profits declining in Division X). I was pretty good at it. If I had to boil down everything I learned in those years to one lesson, it would be this: Pay attention to changes in the mix.

What do I mean by "changes in the mix"? Here is an example. A company has two products. One has a 20% margin, and the other has a 30% margin, and both margins have been improving over time because of a series of cost reduction investments. But overall, company margins are falling. The likely reason: the mix is shifting. The company is selling a higher proportion of the lower margin product.

Here is a real world example: When I was at AlliedSignal (now Honeywell) aviation, they had exactly this problem. They were operating in a razor and blades business -- ie they practically gave the new parts away to Boeing and Airbus to put on their planes, because they made all their money selling aftermarket replacements at a premium (at the time, government rules made it almost impossible to buy anything but the original manufacturer's part, so they could charge almost anything for a replacement, especially given that an airline likely had a $50 million plane sitting dormant until the part was replaced). I routinely would tell managers in the company that essentially our business made money from unreliability -- the less reliable our parts, the more money we made. Because newer technology, competition, and pressure form airlines was forcing us to greatly improve our reliability (at the same time we were giving stuff to Boeing at ever greater losses), all our newer products on newer planes were less profitable than the old stuff. As planes aged and dropped out of the fleet, our product mix was getting less and less profitable.

This same effect can be seen in many economic and political issues. Take for example an argument my mother-in-law and I had years and years ago. She said that Texas (where I was living at the time) had crap schools that were much worse that those in Massachusetts, her argument for the blue political model. She observed that average educational outcomes were much better in MA than TX (which was and still is true). I observed on the other hand that this was in part a result of mix. Texas had better outcomes than MA when one looked at Hispanics alone, and better outcomes for non-Hispanics alone, but got killed on the mix given that Hispanics typically have lower educational outcomes than non-Hispanics everywhere in the US, and Texas had far more Hispanics than MA.

All of this is a long introduction to some thinking I have been doing on all the "Average is Over" discussion talking about the flattening of growth in median wages. I begin with this chart:

There is a lot of interstate migration going on. And much of it seems to be out of what I think of as higher cost states like CA, IL, and NY and into lower cost states like AZ, TX, FL, and NC. One of the facts of life about the CPI and other inflation adjustments of income numbers is that the US essentially maintains one average CPI. Further, median income numbers and poverty numbers tend to assume one single average cost of living number. But everyone understands that the income required to maintain lifestyle X on the east side of Manhattan is very different than the income required to maintain lifestyle X in Dallas or Knoxville or Jackson, MS.

Could it be that even with a flat average median wage, that demographic shifts to lower cost-of-living states actually result in individuals being better off and living better?

For some items one buys, of course, there is no improvement by moving. For example, my guess is that an iPhone with a monthly service plan costs about the same anywhere you go in the US. But if you take something like housing, the differences can be enormous.

Let's compare San Francisco and Houston. At first glance, San Francisco seems far wealthier. The median income in San Francisco is $78,840 while the median income in Houston in $55,910. Moving from a median wage job in San Francisco to a media wage job in Houston seems to represent a huge step down. If you and a bunch of your friends made this move, the US median income number would drop. It would look like people were worse off.

But something else happens when you take this nominal pay cut to move to Houston. You also can suddenly afford a much nicer, larger house, even at the lower nominal pay. In San Francisco, your admittedly higher nominal pay would only afford you the ability to buy only 14% of the homes on the market. And the median home, which you could not afford, has only about 1000 square feet of space. In Houston, on the other hand, your lower nominal pay would allow you to buy 56% of the homes. And that median home, which you can now afford, will have on average 1858 square feet of space.

So while the national median income numbers dropped when you moved to Houston, you actually can afford a much nicer home with perhaps twice as much space. Thus, it strikes me that there are important things happening in the mix that are not being taken into account when we say that the "average is over".

Of course, while this effect is certainly real, I have no idea how much it affects the overall numbers, ie is it a small effect or a large effect. Fortunately my son is studying economics in college. If he ever goes to grad school, I will add this to my list of research suggestions for him.

Postscript: This exact same discussion could apply to US poverty statistics. We have one poverty line income number whether you live in Manhattan or Tuscaloosa. I have always wondered how much poverty statistics would change if you created some kind of purchasing power parity test rather than a fixed income test.

You often hear people say that one of the main reasons for health care inflation is the cost of all the new technology. But can you name any other industries that compete in free markets where technology introductions have caused inflation rates to run at double the general rate of inflation? In fact, don't we generally associate the introduction of technology with reduced costs and increased productivity?

Compare a McDonald's kitchen today with one thirty years ago -- there is a ton of technology in there. Does anyone think that given the price-sensitive markets McDonald's competes in, this technology was introduced to increase prices?

Or look at medical fields like cosmetic surgery or laser eye surgery. Both these fields have seen substantial introductions of new technology, but have seen inflation rates not only below the general health care inflation rate but below the CPI, meaning they have seen declining real prices for decades.

The difference is not technology, but the pricing and incentive system. Cosmetic surgery and laser eye surgery are exceptions in the health care field -- they are generally paid out of pocket rather than by third parties (Overall, third party payers pay about 88% of all health care bills in the US).

The problem with health care is not technology -- the problem is that people don't shop for care with their own money.

Postscript: Thinking some more after I wrote this, I can think of one other industry where introduction of technology has coincided with price inflation well above the CPI -- education. It is interesting, but not surprising to me, that this is the other industry, along with health care, most dominated by third party payer systems and public subsidies of consumers.

Opponents of free trade will often say publicly that they are all for free trade but it must be "fair," which they generally would define as balanced between imports and exports. This is a dodge, because they know many of our trading partners are not going to open up trade to be entirely free so they can use that inevitability as an excuse not to remove American protectionist barriers.

But trade does not need to be balanced to create wealth, and in fact it is not just exports that provide a boost to real incomes. Daniel Ikenson at Cato has these two charts comparing the CPI for items that face competition from imports and those that don't:

See his article for more discussion.

This is also related to something I read about a while back, that we may be underestimating income gains among the lower income quartiles in this country because we adjust to real wages based on an average inflation rate. The argument was that the inflation rate for the poor has been lower (the Wal-Mart effect) than the inflation rate for the rich (prices at the Four Seasons keep going up). One estimate put the difference in inflation rates as high as 6 percentage points, in part because the poor proportionally consume a lot of goods that are imported while the rich consume proportionally a lot of services that are produced domestically with high cost labor.

A number of politicians are calling for taxing "windfall profits" driven by the "price bubble" in gasoline and oil. Previously, I narrow-mindedly opposed this, arguing that the whole point of the pricing signal being sent is to call for new supplies, which won't happen if the government takes the money away from suppliers.

I say narrow-mindedly, because I have had an epiphany. I realize now that it is indeed unfair for sellers to benefit from such a pricing bubble. However, I think the politicians are wrong for looking at oil, since that bubble is only small potatoes. I propose we start with the much bigger bubble: In housing prices. In a time of housing shortages, it pains my heart to Americans profiteering from artificially high prices. Besides, oil companies actually do something useful with their windfall profits, like finding more oil; home sellers will just blow their proceeds on a big screen TV or something.

My proposal is that the government set a "fair price" for housing, based on a standard rate of appreciation. The price of the house in a base year, such as 1970, adjusted for the CPI is a good starting point, but a process can be created modeled after Hawaiian gas pricing regulation to set up the exact standard. Every house in the country then will be appraised. Any house selling for or appraised for an amount above the 1970 price+CPI adjustment will be deemed as having reaped windfall profits. The government is authorized to seize 100% of these windfall profits. When this program is a success, we should then consider a retroactive program to seize windfall profits from the Internet stock bubble.

So, for all you who were supporting government intervention into gasoline pricing and profits, this must make you feel even better, since it is a much, much bigger bubble. Right? Or was it somehow more fun when Exxon was a target instead of, say, you?

Update: I thought it was obvious, but I guess not from the email I have gotten: I am being sarcastic here. I would oppose a "windfall" profits tax on oil, houses, Internet Stocks, Pokeman cards, or whatever.

We keep hearing the word "bubble" to describe
industries with rapid and unsustainable rising prices. Hence, the
Internet bubble, the telecom bubble, stock market bubble, and now, some
analysts believe, a housing bubble. Yet for some mysterious reason no
one speaks of the oil bubble -- though prices have tripled in two years
to as high as $70 a barrel.

Reviewing the history of oil-market boom and bust
confirms that we are in the midst of a classic oil bubble and that
prices will eventually fall, perhaps dramatically. Despite apocalyptic
warnings, the world is not running out of oil and the pumps are not
going to run dry in our lifetimes -- or ever. What's more, the
mechanism that will surely prevent any long-term catastrophic shortages
in energy is precisely the free-market incentive to make profits that
many politicians in Washington seem to regard as an evil pursuit and
wish to short circuit.

The best evidence for an oil bubble comes from the
lessons of America's last six energy crises dating back to the late
19th century, when there was a great scare about the industrial age
grinding to a halt because of impending shortages of coal. (Today coal
is superabundant, with about 500 years of supply.) Each one of these
crises has run almost an identical course.

First, the crisis begins with a spike in energy prices
as a result of a short-term supply shock. Next, higher prices bring
doomsday claims of energy shortages, which in turn prompts government
to intervene ineffectually into the marketplace. In the end, the advent
of new technologies and new energy discoveries -- all inspired by the
profit motive -- brings the crisis to an abrupt end, enabling oil and
electricity markets to resume their virtuous longterm downward price
trend.

The limits-to-growth crowd has predicted the end of
oil since the days when this black gold was first discovered as an
energy source in the mid-19th century. In the 1860s the U.S. Geological
Survey forecast that there was "little or no chance" that oil would be
found in Texas or California. In 1914 the Interior Department forecast
that there was only a 10-year supply of oil left; in 1939 it calculated
there was only a 13-year supply left, and in 1951 Interior warned that
by the mid-1960s the oil wells would certainly run dry. In the 1970s,
Jimmy Carter somberly told the nation that "we could use up all of the
proven reserves of oil in the entire world by the end of the next
decade."

We can ridicule these doom and gloom predictions
today, but at the time they were taken seriously by scholars and
politicians, just as the energy alarmists are gaining intellectual
traction today. But as the late economist Julian Simon taught, by any
meaningful measure oil (and all natural resources) has gotten steadily
cheaper and far more bountiful in supply over time, despite periodic
and even wild fluctuations in the market.